George Trapp
Northern Trust

Shifting market demands and regulatory change are making for an interesting year in the collateral marketplace, as Northern Trust’s George Trapp explains

How have interest rate hikes in the US affected demand for corporate bond collateral?

Rate hikes in the US have an offsetting effect between cash and non-cash collateral. For example, you tend to see spread compression in the lead up to a rate hike. I’ve seen anticipation of higher rates recently, which created some improved value in cash collateral. At the same time, last year’s money market reform in the US also created value in the investment of cash collateral.

From 2016, there was a differentiation between yield on US government bonds and yield in short-duration fixed-income credit product. That’s where there was some value creation and difference between the overnight rate in the cash market for US dollars and the three-month libor rate. But, in the first half of 2017, that spread difference has lessened so the benefit of taking cash has been reduced, compared to 2016.

Generally, the economy and the geopolitical environment, have adjusted expectations for interest rates and growth. Expectations are that the Federal Reserve’s interest-rate hike cycle has probably slowed down relative to what the market anticipated in 2016. We saw rate hikes last year in December, and in March and June this year, but I don’t think we’ll see another one for the rest of this year. At the same time, the Trump administration hasn’t generated the environment for growth that was expected. I think there is still a big question around the impact of higher interest rates on the securities lending market.

The US market has been shifting towards greater use of non-cash collateral. Are the recent hikes causing a blip in the trend or are we likely to see a more significant slowing or reversal of this trend?

I do think the trend will continue. In the US, some of our client base can take equities as collateral and the concern is how balances will be affected for those clients that don’t accept a wide range of collateral. For example, corporate pension plans can’t take them today, due to regulatory constraints. But, we do have public funds, foundations and endowments that take equities with collateral.

Cash is still a very efficient way to clear a securities lending transaction in the US. You have some restrictions around taking securities like equities as collateral in the US, both for mutual fund and Employee Retirement Income Security Act clients. I think those barriers affect the volumes increasing in terms of equities as collateral rising higher. Until those rules change, you will see cash as a popular form of collateral.

Do you see a push from your lending client base to achieve some regulatory reform on collateral usage?

I don’t see that push coming from our beneficial owners, that push comes more from the borrowers, who are incentivised to have reform so that they can pledge more of their equities as collateral. That’s probably one of the primary drivers.

Lending agents, like ourselves, working on behalf of our clients, also try to broaden that collateral to include equities, but I just don’t see that push from them.

If Dodd-Frank is rolled back in a significant way, do you think it will have a big impact on securities lending?

It will have an impact, but I am not sure how big. The demand to borrow securities, generally, has been cut in half, even though the supply of securities to lend is back to where it was pre-crisis. A lot of leverage has come out of the system, and a lot of investment has gone into regulatory requirements and the capital required to support that.

If regulation is rolled back or lessened to the benefit of the industry, I think that there will be an increase of activity and some of the lower spread trades that aren’t happening today may come back into favour. Any change in regulation that reduces that cost will ultimately help activity. It might not be immediate, but the market will react to it and benefit over time.

Might a regulatory rollback allow banks to re-engage in the market and subsequently curb the rise of all-to-all platforms?

That has a lot to do with diversifying counterparty risk, having more efficient ways to getting supply and demand together. I think some of that roll back of regulation would just generally stimulate activity in the marketplace, although I don’t know what the direct impact would be on some of the peer-to-peer platforms.

I don’t know if we would change our own activity in response to that. Northern Trust’s activity has been pretty consistent and in line with the industry.

Currently, there is $2.2 trillion on loan and closing in on $20 trillion in terms of securities available. We’ve seen innovative new models come and go through the years and it’s hard to say what a change in regulation would do to new platforms, other than continuing to stimulate activity.

Securities lending revenue dropped significantly in the first two quarters of this year. Was that more to do with a bumper 2016 rather than a downturn this year?

Clients that were taking cash collateral that could be invested in prime money market funds experienced strong returns at the end of 2016 and beginning of 2017, so it wasn’t bad news for everyone.

But there was a drop in revenue from the intrinsic demand component in the equity markets for securities lending, as well as less demand for specific trades and trade activity. That probably had more to do with the lower volatility and higher equity prices.

There was less demand for the ‘end user’ of the securities and hedge funds that are borrowing.

The volatility in the marketplace has been at an all-time low, but I think those were really the main contributors to a lessening demand in the first half of the year for securities lending.

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